Whitney Tilson Is Wrong About Lumber Liquidators

Shares of Lumber Liquidators (NYSE: LL) sold off sharply Friday afternoon after hedge fund manager Whitney Tilson revealed a short position in the fast-growing hardwood flooring retailer. As an analyst who has followed both Lumber Liquidators and Tilson closely for years, I was surprised to learn that Tilson was betting against a company that I believed to possess sustainable competitive advantages, a strong balance sheet, and a stellar management team. Was I missing a critical red flag?

Fortunately, after reviewing Tilson's short thesis, I'm no longer concerned that my assessment of Lumber Liquidators is flawed. In fact, I think Tilson is wrong about the company.

I'll address the key points of Tilson's short thesis in a moment. But first, I think it's instructive to review Tilson's history in shorting stocks, as well as the lessons he claims to have learned.

A short recap of Tilson's shorting historyTilson's hedge fund badly lagged the S&P 500 in 2010 due to significant losses in his short book, including a very public, very poorly timed bet against Netflix. After Tilson finally capitulated and closed his Netflix short in early 2011, he reassessed the role of shorting in his portfolio in a letter to his investors. Here are some excerpts, with emphasis added in bold:

Over time we've been quite successful shorting fads, frauds, promotions, declining businesses, and bad balance sheets. Where we have had much less success, however, especially in recent months, is shorting good businesses that are growing rapidly, even when their valuations appear extreme. Such open-ended situations, regardless of valuation, are very dangerous, so going forward we will avoid them entirely unless we have a high degree of conviction about a specific, near-term catalyst.

We're embarrassed to admit -- we pushed to the back of our minds two facts that have always been true: 1) shorting is a terrible business ... and 2) we're much better long investors than short investors. Said another way, long investing is a massively better business than shorting, plus our experience, skill set and temperament is much better suited to it. We will not forget this again.

He forgot it againAt last week's Robin Hood Investors Conference, Tilson presented his short case for Lumber Liquidators. Based on his PowerPoint slides, the main crux of Tilson's short thesis seems to be that substantially all of Lumber Liquidators' recent gross margin improvement can be attributed to sourcing low-cost product from China. Tilson believes that "a meaningful percentage" of Lumber Liquidators' Asian-sourced wood "is from Chinese mills that are trafficking in illegal wood," and "a meaningful portion of [Lumber Liquidators'] margin expansion could be due to buying illegal wood." Finally, Tilson claimed that resolving this issue "is likely to disrupt [Lumber Liquidators'] supply chain and materially impact margins."

Let's take a look at Tilson's claims to see whether Lumber Liquidators shareholders should be concerned.

Tilson says: Lumber Liquidators' "high [operating] margins make no sense in light of the commodity product and ferocious competitive environment."

It's true that Lumber Liquidators sells similar products as its peers. But Lumber Liquidators provides a distinct customer experience in terms of service, selection, and price. Lumber Liquidators offers a wider selection of flooring options than Home Depot and Lowe's, in a nicer atmosphere, with a more knowledgeable sales staff, and lower prices. When you consider that Lumber Liquidators stores are a fraction of the size of its big-box competitors' and operate with a much leaner staff, it's no surprise that the company boasts higher margins. This is the equivalent of claiming that Starbucks and Safeway should have similar margin profiles because both companies sell coffee.

This statement is accurate, but I believe Tilson misunderstands the source of those reduced product costs. As you can see in the chart below, Lumber Liquidators' margins have been on a steady upswing over the last two years.

2Q11

2Q12

2Q13

Gross Margin

34%

37.3%

41.3%

Source: S&P CapitalIQ.

Tilson attributed Lumber Liquidators' margin improvement to an increase in the percentage of product sourced from China. In a sense, he is correct -- buying additional inventory from lower-cost Asian locations has certainly contributed to the company's gross margin expansion. But Tilson conveniently overlooks another factor that led to significant margin expansion at Lumber Liquidators: CEO Rob Lynch.

Upon joining the company in early 2011, Lynch implemented a series of margin-improving strategic initiatives, including regular product line reviews, additional direct mill sourcing, and transportation cost reductions. These initiatives have likely added hundreds of basis points to Lumber Liquidators' margins, and Tilson didn't mention any of them.

Furthermore, Tilson assumes that Lumber Liquidators' gross margin expansion was only due to lower costs. But that's not the case -- Lumber Liquidators has also benefited from a sales mix shift toward higher-margin products. A new marketing campaign, a revamped store prototype, and better trade locations are attracting a more casual consumer. Thanks to assistance from the better-trained sales staff (another Lynch initiative), these customers tend to purchase higher-margin products, including moldings and accessories.

So while some of Lumber Liquidators' gross margin improvement is due to increased sourcing from China, a large portion is due to the separate initiatives.

This is the crux of Tilson's short thesis -- the specific, near-term, high-conviction catalyst he requires to short a stock. Surprisingly, Tilson provided no data to support these statements. While it's true that federal authorities are investigating Lumber Liquidators' importation of certain wood flooring products, the company has not released details about the scope of the investigation. It's not clear how many mills will be affected (if any), and what percentage of Lumber Liquidators' product supply they represent.

It is certainly possible that Lumber Liquidators will pay a fine related to the importation of illegal wood. The company may need to incur additional compliance costs going forward, and it is also possible that its supply chain will be temporarily disrupted. But I am aware of no data that supports Tilson's claims. If he has evidence, he certainly didn't include it in his presentation.

A dangerous shortI was concerned when I learned that Tilson was short Lumber Liquidators, but I found his case against the company to be surprisingly weak. It's certainly possible that Lumber Liquidators' margins will be affected by the Chinese sourcing issue. But there isn't sufficient information available to determine how significant the impact might be. Tilson provided no factual basis for his claim that the impact will be material, and I believe he has overestimated the benefit that Lumber Liquidators derives from its China-sourced products.

Lumber Liquidators is neither a fad nor a fraud. The balance sheet is strong and the business has plenty of room left to run. And while I don't consider the stock a screaming buy at current prices, I certainly don't believe the valuation is extreme. In other words, this is the exact type of stock that Tilson tells us is very dangerous to short.

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Why is it that, presented with the same numbers for a company, each "analyst" can come up with a different opinion about its performance/health and recommendation about its stock? Each "analyst" substantiates his opinion quite eruditely but, as it turns out, most of them are wrong most of the time. It seems that chicken entrails or tea leaves would provide just as accurate reading. It's a toss up who gets lower precentage of their predictions right, stock analysts or weather forecasters. For certain neither group has a better record than shamans and/or fortune tellers.

Hi Fools, I received an email from Whitney Tilson. His response is posted below:

Hi Rich,

I tried posting this in the Comments section after your article, apparently without success. Can you post for me?

Thanks,

Whitney

----------------------

In my presentation (posted at www.tilsonfunds.com/LL.pdf), I did, in fact, mention the many factors that contributed to LL's increased margins, quoting directly from the CFO (see page 10). But I stand behind my statement that "I believe that a substantial fraction of LL's gross (and operating) margin expansion is due simply to buying the same products for less."

Today, Lumber Liquidators issued this response to my presentation:

"Mr. Tilson did not contact the company in compiling his presentation and we have never met with him to discuss our business. Mr. Tilson’s presentation is based entirely on his own speculation and the contents of a report released almost two months ago which we had previously stated contained numerous inaccuracies and unsubstantiated claims. Lumber Liquidators is committed to uncompromising integrity in how the Company operates, across all areas of the business. We have policies and procedures in place for the sourcing, harvesting and manufacturing of all of our products, monitored by professionals located around the world. We support the protection of the environment and responsible forest management, and we invest significant time and resources to safeguard quality control and compliance. As a result of our processes, we diversify our sourcing across more than 100 suppliers, which affords us the flexibility to make changes to meet consumer trends and move business away from any supplier unwilling to comply with our policies. If we find that any of the Company’s suppliers are not adhering to our standards, we will discontinue sourcing from those suppliers. It is important to note that no single mill provides more than 4% of our hardwood purchases and no single hardwood product represents more than 1% of our sales mix."

Here is my reply:

Lumber Liquidators asserts that the EIA report “contained numerous inaccuracies and unsubstantiated claims”, but has yet to provide even one fact to rebut the report, which I found to be an extremely impressive piece of investigative work – and 100% consistent with everything we know about the wild-west business environment in Russia and China: widespread corruption, weak rule of law, little concern for the environment, etc.

Federal authorities obviously think the EIA report is credible, as agents from the Department of Homeland Security's Immigration and Customs Enforcement and the U.S. Fish and Wildlife Service on September 26th raided LL’s headquarters, executing sealed search warrants "which relate to the importation of certain of the Company's wood flooring products."

Lumber Liquidators’s only response has been to say (on the Q3 earnings conference call), "We are continuing to cooperate fully with the authorities to provide them with the requested information and there is no update or additional information pertaining to the request that we can provide at this time." The company’s silence speaks volumes.

Lumber Liquidators’s second line of defense appears to be that even if the EIA report is correct, it focuses on only one supplier, which the company can simply stop sourcing from with minimal disruption since “no single mill provides more than 4% of our hardwood purchases and no single hardwood product represents more than 1% of our sales mix.”

I’m skeptical that this is an isolated problem limited to one rogue supplier. Rather, the combination of a) the evidence in the EIA report, b) the unusually rapid increase in Lumber Liquidators’s margins to unprecedented levels immediately after acquiring a Chinese supply chain company, and c) the hugely corrupt business environment in both Russia and China lead me to believe that Lumber Liquidators has a big problem on its hands. Though I can’t prove it, the evidence I see, combined with common sense, makes me think it’s highly likely that what EIA has uncovered is a pervasive problem across Lumber Liquidators’s Chinese supply chain.

Since the raid, I assume that the company is scrambling to show the authorities that whatever problems are in their supply chain are isolated cases, they didn't know about it, etc. But keep in mind that the authorities raided Lumber Liquidators based on the EIA report, so they're not going to be easily fooled by some spin and token actions. Rather, I think Lumber Liquidators right now has no choice but to very quickly clean up its act to avoid major sanctions by the authorities.

Specifically, I think Lumber Liquidators will have to: 1) immediately stop sourcing from suppliers they even suspect are trafficking in illegal wood; 2) find replacement suppliers; and 3) ensure their entire worldwide supply chain is pristine. Doing all of these things is likely to be very costly and disruptive to the business – not to mention management being distracted by having to deal with the authorities for the foreseeable future.

These things might not matter if the stock were cheap, but it’s not: after a 7x run-up in less than two years, it trades at 40x trailing earnings and 22x trailing EBITDA.

My two-year price target is $53 (and I think I’m being generous) based on the following back-of-the-envelope math:

• Sales grow 16% annually in the next two years, as analysts expect (resulting in revenue of $1.35 billion)

• Operating margins give back half of the 830 basis point increase in the last nine quarters and fall to 9% (still far above the long-term average)

• The market responds to this by assigning the stock a 20x P/E multiple

As someone who recently shopped for wood floors, I found that LL's claims of quality, service, and superior pricing specious (regardless of where they source their wood). Drop shipment means the end of your driveway, you better be home if the weather is bad, and have a strong back; order more than you think you need (destroying any price advantage) as you will be getting numerous small and/or mismatched pieces; if you're using laminate in more than one color, you may not get what your ordered, so make sure that you have a creative installer; and if you want to buy U.S. sourced wood, go elsewhere. A company is what a company does; it's either a good company or not. Their marketing is good however, so maybe there is still room for stock share growth.

Shorters are generally a great impediment to any notion that the market is based on facts. They silently acquire large short positions, and then on an opportune day for themselves they find a platform to denounce a company. Investors panic (even IBD urged its readers to sell off their LL holdings). Then the shorters make a big profit. But the effiiciency of the market has been raped and the holdings of ordinary investors robbed as surely as if the shorter had taken their money at gunpoint.

There must be regulation that a shorting entity must report publicly any weekly short acquisitions in excess of $1 million. Otherwise Graham & Dodd

Mr Tilson is not wrong. Just wait until the real issue comes out: Indoor air quality and non compliant OSHA -CARB products from importers of hardwood flooring. Illegal logging for some will be a very small issue in comparison. This is just starting to play out and has far worse consequences for offenders. Tilison is just ahead of that curve and I suspect aware of this larger issue. Go buy a carton of that hardwood and have it tested for VOC content if you doubt this. Wait for the day you see one of those law firms commercials talking about some drug companies pill that may have caused something to happen, that defective hip replacement you are owed $200k for etc., get a hold of this scenario: little Johnny has nose bleeds now and a blood chemistry far from normal and little Johnny’s physician has the prior blood work to substantiate this change ONLY after mommy buys a new wood floor. For the record, I am NOT anti import. Some mix of products need to be imported as US factories become lazy without the competition and in the hardwood industry, that is exactly what occurred. Lazy and content US producers fell way behind on both quality and fashion and others took up their slack. Sad but true. But US producers appear to be waking up..... finally.

I'm neither short nor long on LL, but I get nervous when a company is accused of what I would term unethical practices. Right or wrong, this usually has an adverse effect on the stock price short term. For that reason alone, I wouldn't touch it now.

What people don't seem to remember about LL is that the prior CEO was terrible. He formerly ran Electronic's Boutique and had no experience with a physical manufacturing supply chain. When Rob Lynch took over he simply used LL's purchasing power to request lower prices from their vendors (a line review). Something the previous management team did not know they could do. Why is it so bad that their purchasing power (a competitive advantage) was responsible for a couple hundred basis points in addition to the other initiatives that an experienced management team implemented?

It's short sighted that all of LL's gross margin improvement came from illegal wood, especially when the EIA report suggests that such wood was being used years ago before the marign improvement existed!

Is it so surprising that a good operator could come in and raise margins as much as he did after a bad management team, a cyclical downturn and a botched SAP implementation?

In the report, Wedbush noted, “We believe CEO Rob Lynch has transformed LL into a best-in-class vertically-integrated growth retailer with enormous tailwinds supporting a medium-term 30% EPS growth rate on top of 63% growth in 2013. Despite the stock's strong run, we see continued upside driven by fundamental outperformance and expect resolution to the sourcing issue overhang in due course. LL shares have been under pressure recently primarily due to concerns over its Asian sourcing operations. We spent considerable time investigating these operations and suppliers by consulting experts on Asian flooring imports and Chinese resources. We found no evidence of widespread negligence and believe this issue will be resolved in isolation, with minimal repercussions. Moreover, if there was illegal sourcing, it is extremely unlikely that it was a significant driver of gross margin expansion for LL as potentially illegally sourced wood types represent a small portion of LL sales.”

Wow...I was cleaning out my Email and ran across one from a year ago with a link to this article. It was published a year and a day ago. On that day, LL closed at $102.97. Today it's at $62.50. Only for one extremely brief time in early 2014 was it ever higher than the $102.97 close a year ago. Since then, it is down 39%. Looks like Whitney Tilson wins this one!